Reverse and construction exchanges are made easier by tax court case.
On Aug. 10, 2016, the United States Tax Court issued an opinion in the case of George H. Bartell et al., v. Commission of Internal Revenue, 14 T.C. No. 5. This case may prove to be the most momentous tax authority dealing with 1031 exchanges in the last 20 years. It is very favorable to taxpayers and deals primarily with “reverse” 1031 exchanges.
In the case, the taxpayer used an unrelated holding company as a strawman to purchase and build on a piece of vacant land. In the agreement, the completed project was identified, from the beginning, as replacement property in a “reverse” 1031 exchange.
The project took 17 months to complete. During that time, all of the following conditions were part of the agreement between the holding company and the taxpayer/exchanger:
1. The taxpayer had all of the benefits and burdens of ownership.
2. The taxpayer had the market risk of any increase or decrease in value while the property was “parked.”
3. The taxpayer had the risk of loss of any decline in value of the property.
4. The project was to be transferred, upon completion, to the taxpayer for the costs to buy, build and hold, as replacement property.
5. The taxpayer loaned funds to the holding company on a nonrecourse basis.
6. The taxpayer had the other burdens of ownership, such as taxes and other liabilities.
7. The taxpayer financed and directed construction of improvements. All lending was nonrecourse as to the holding company. The construction lender acknowledged its understanding that the project to be part of a 1031 exchange.
8. The taxpayer had possession of the property under a lease, both during construction and after completion.
9. It was the clear intent of the agreement that this project was to be a replacement property in a 1031 exchange.
10. The taxpayer did not own the relinquished property when the holding company first bought the replacement land and started construction. Instead the relinquished property was acquired by the taxpayer after legal title to the replacement project was already in the name of the holding company.
In short, the holding company had bare legal title to the project and an agreement that the transaction was to be part of a 1031 exchange for the taxpayer.
After completion of the project, the taxpayer sold its relinquished property and used the funds to buy the replacement property from the holding company at cost. The holding company was paid a fee for service only. The holding company had no business risk in the transaction.
The IRS challenged the validity of the1031 tax-deferred treatment claimed by the taxpayer, arguing that the holding company must have the “benefits and burdens” of true ownership during its holding period. The Tax Court rejected this argument and ruled in favor of the taxpayer.
We are still in the period of time when the IRS can appeal this ruling to the U.S. Circuit Court of Appeals, but right now following this case could be a justifiable strategy for a taxpayer.
1031 exchanges are a more powerful tool than ever for the real estate investor. But they remain full of arcane requirements and strategies. And each situation has its own unique aspects. That is why it is imperative that investors do their own thorough due diligence and seek and heed the advice of a tax and/or legal professional in this area.